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FINANCIAL MANAGEMENT Notes
FINANCIAL MANAGEMENT Notes
management
Notes
FINANCIAL MANAGEMENT
Financial management is an academic discipline which is concerned with
decision-making. This decision is concerned with the size and composition of
assets and the level and structure of financing. In order to make right
decision, it is necessary to have a clear understanding of the objectives. Such
an objective provides a framework for right kind of financial decision making.
The objectives are concerned with designing a method of operating the
Internal Investment and financing of a firm. There are two widely applied
approaches, viz.
2) Timing of Benefits:
Another technical objection to the profit maximization criterion is that It
Ignores the differences in the time pattern of the benefits received from
Investment proposals or courses of action. When the profitability is worked
out the bigger the better principle is adopted as the decision is based on
the total benefits received over the working life of the asset, Irrespective of
when they were received. The following table can be considered to explain this
limitation.
3) Quality of Benefits
Another Important technical limitation of profit maximization criterion is that
it ignores the quality aspects of benefits which are associated with the
financial course of action. The term 'quality' means the degree of certainty
associated with which benefits can be expected. Therefore, the more certain
the expected return, the higher the quality of benefits. As against this, the
more uncertain or fluctuating the expected benefits, the lower the quality of
benefits.
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Wealth Maximization Decision Criterion
ii) Quality and Quantity and Benefit and Time Value of Money:
The more certain the expected cash in flows the better the quality of benefits
and higher the value. On the contrary the less certain the flows the lower the
quality and hence, value of benefits. It should also be noted that money has
time value. It should also be noted that benefits received in earlier years
should be valued highly than benefits received later.
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IMPORTANT FUNCTIONS OF THE FINANCIAL MANAGER:
The important function of the financial manager in a modern business consists
of the following:
1. Provision of capital: To establish and execute programmes for the
provision of capital required by the business.
2. Investor relations: to establish and maintain an adequate market for the
company securities and to maintain adequate liaison with investment
bankers, financial analysis and share holders.
3. Short term financing: To maintain adequate sources for company’s
current borrowing from commercial banks and other lending institutions.
4. Banking and Custody: To maintain banking arrangement, to receive, has
custody of accounts.
5. Credit and collections: to direct the granting of credit and the collection
of accounts due to the company including the supervision of required
arrangements for financing sales such as time payment and leasing
plans.
6. Investments: to achieve the company’s funds as required and to
establish and co-ordinate policies for investment in pension and other
similar trusts.
7. Insurance: to provide insurance coverage as required.
8. Planning for control: To establish, co-ordinate and administer an
adequate plan for the control of operations.
9. Reporting and interpreting: To compare information with operating
plans and standards and to report and interpret the results of operations
to all levels of management and to the owners of the business.
10. Evaluating and consulting: To consult with all the segments of
management responsible for policy or action concerning any phase of
the operation of the business as it relates to the attainment of
objectives and the effectiveness of policies, organization structure and
procedures.
11. Tax administration: to establish and administer tax policies and
procedures.
12. Government reporting: To supervise or co-ordinate the preparation of
reports to government agencies.
13. Protection of assets: To ensure protection of assets for the business
through internal control, internal auditing and proper insurance
coverage.
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DEBENTURES
Kinds of Debentures
1. Bearer Debentures: They are registered and are payable to its bearer
.They are negotiable instruments and are transferable by delivery.
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7. Convertible Debentures: If an option is given to convert debentures into
equity shares at stated rate of exchange after a specified period they
are called convertible debentures. In our country the convertible
debentures are very popular. On conversion, the holders cease to be
lenders and become owners. Debentures are usually issued in a series
with a pari passu (at the same rate) clause which entitles them to be
discharged rate ably though issued at different times. New series of
debentures cannot rank pari passu with old series unless the old series
provides so.
11. Third Party convertible Debentures: They are debt with a warrant
allowing the investor to subscribe to the equity of a third firm at a
preferential vis-à-vis the market price. Interest rate on third party
convertible debentures is lower than pure debt on account of the
conversion option.
12. Convertible Debentures Redeemable at a premium: Convertible
debentures are issued at face value with an option entitling investors to
later sell the bond to the issuer at a premium. They are basically similar
to convertible debentures but embody less risk.
BALANCE SHEET
1) Assets
2)
3) Liabilities
Assets:
The assets in the balance sheet are listed either in the order of liquidity-
promptness with which they are expected to be converted into cash- or in
reverse order, that is, fixity or listing of the least liquid asset first, followed by
others. All assets are grouped into categories, that is, assets with similar
characteristics are put into one category. The assets included in one category
are different from those in other categories. The standard classification of
assets divides them into:
Liabilities:
The second major content of the balance sheet is liabilities of the firm.
Liabilities may be defined as the claims of outsiders against the firm.
Alternatively, they represent the amount that the firm owes to outsiders that
is, other than owners. The assets have to be financed by different sources.
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One source of funds is borrowing- long term as well as short term. The firms
can borrow on a long term basis from financial institutions/ banks or through
bonds/ mortgages/ debentures.
The short term borrowing may be in the form of purchase of goods and
services on credit. These outside sources from which a firm can borrow are
termed as liabilities. Since they finance the assets, they are, in a sense,
claims against the assets. The amount shown against the liability items is on
the basis of the amount owed, not the amount payable.
Depending upon the periodicity of the funds, liabilities can be classified into
1) Long-term liabilities
Current liabilities
TO PURCHASES BY SALES
TO OPENING STOCK
BY CLOSING STOCK
TO WAGES
TO CARRIAGE
TO GROSS PROFIT
TO SELLING EXPS.
TO FINANCIAL EXPS.
TO NET PROFIT
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BALANCE SHEET AS ON
LIABILITIES ASSETS
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GIVEN BELOW ARE THE MODERN FORMS OF TRADING AND PROFIT &
LOSS ACCOUNT AND THE BALANCE SHEET
I. NET SALES
OPENING STOCK
+ PURCHASES
+ WAGES
- CLOSING STOCK
X. LESS: TAX
I. sources of funds
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1. SHAREHOLDERS FUNDS
EQUITY CAPITAL
PREFERENCE SHARE CAPITAL
2. BORROWED FUNDS
SECURED LOANS
UNSECURED LOANS
XXXXX
FIXED ASSETS
INVESTMENTS
WORKING CAPITAL
CURRENT ASSETS
LESS:
CURRENT LIABILITIES
XXXXX
RATIO ANALYSIS
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are several ratios at the disposal of the analyst but the group of ratios he
would prefer depends on the purpose and the objectives of the analysis.
1) Fraction
2) Percentages
3) Proportion of numbers
These alternative methods of expressing items which are related to each other
are, for purposes of financial analysis, referred to as ratio analysis. It should
be noted that computing the ratio does not add any information in the figures
of profit or sales. What the ratios do is that they reveal the relationship in a
more meaningful way so as to enable us to draw conclusions from them.
• Ratios avoid distortions that may result the study of absolute data or
figures
• Ratios study the past and relate the findings to the present. Thus useful
inferences are drawn which are used to project the future.
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• Ratios being measures of efficiency can be used to control efficiency and
profitability of a business entity.
An investor should caution that ratio analysis has its own limitations. Ratios
should be used with extreme care and judgment as they suffer from certain
serious drawbacks. Some of them are listed below:
4. Changes in the price level make the interpretations of the ratios Invalid.
The interpretation and comparison of ratios are also rendered invalid by the
changing value of money. The accounting figures presented in the financial
statements are expressed in monetary unit which is assumed to remain
constant. In fact, prices change over years and as a result. Assets acquired at
different dates will be expressed at different values in the balance sheet. This
makes comparison meaningless.
For e.g. two firms may be similar in every respect except the age of the plant
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and machinery. If one firm purchased its plant and machinery at a time when
prices were very low and the other purchased when prices were high, the
equal rates of return on investment of the two firms cannot be interpreted to
mean that the firms are equally profitable. The return of the first firm is
overstated because its plant and machinery have a low book value.
7. The ratios calculated at a point of time are less informative and defective as
they suffer from short-term changes. The trend analysis is static to an extent.
The balance sheet prepared at different points of time is static in nature. They
do not reveal the changes which have taken place between dates of two
balance sheets. The statements of changes in financial position reveal this
information, bur these statements are not available to outside analysts.
8. The ratios are generally calculated from past financial statements and thus
are no indicator of future. The basis to calculate ratios are historical financial
statements. The financial analyst is more interested in what happens in
future.
While the ratios indicate what happened in the past Art outside analyst has to
rely on the past ratios which may not necessarily reflect the firm’s financial
position and performance in future.
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resource basis, working capital basis and cash basis. The most commonly
accepted form of fund flow is the one prepared on working capital basis.
A fund flow statement is different from cash flow statement in the following
ways –
i). Funds flow statement is based on the concept of working capital while cash
flow statement is based on cash which is only one of the element of working
capital. Thus cash flow statement provides the details of funds movements.
ii). Funds flow statement tallies the funds generated from various sources with
various uses to which they are put. Cash flow statement records inflows or
outflows of cash, the difference of total inflows and outflows is the net
increase or decrease in cash and cash equivalents.
iii). Funds Flow statement does not contain any opening and closing balance
whereas in cash flow statement opening as well as closing balances of cash
and cash equivalents are given.
iv). Funds Flow statement is more relevant in estimating the firm’s ability to
meet its long-term liabilities, however, cash flow statement is more relevant
in estimating the firms short-term phenomena affecting the liquidity of the
business.
v). The Cash Flow statement considers only the actual movement of cash
whereas the funds flow statement considers the movement of funds on
accrual basis.
vi). In cash flow statement cash from the operations are calculated after
adjusting the increases and decreases in current assets and liabilities. In
funds flow statement such changes in current items are adjusted in the
changes of working capital.
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vii). Cash flow statement is generally used as a tool of financial analysis which
is utilized by the management for short- term financial analysis and cash
planning purposes, whereas funds flow statement is useful in planning
intermediate and long-term financing.
Investors are able to measure as to how the company has utilized the
funds supplied by them and its financial strengths with the aid of funds
statements.
The term cost of capital means the overall composite cost of capital defined as
“weighted average of the cost of each specific type of fund. The use of
weighted average and not the simple average is warranted by the fact that
proportions of various sources of funds in the capital structure of a firm are
different.
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Therefore the overall cost of capital should take into account the weighted
average. The weighted cost of capital based on historical weights takes into
account a long-term view.
Thus, the weighted average cost of funds of a company is based on the mix of
equity and loan capital and their respective costs. A distinction is usually
drawn between the average cost of all funds in an existing balance sheet and
the marginal cost of raising new funds.
The operating cycle is the length of time between the company’s outlay on
raw materials, wages and other expenditures and the inflow of cash from the
sale of the goods. In a manufacturing business, operating cycle is the average
time that raw materials remain in stock less the period of credit taken from
suppliers, plus the time taken for producing the goods, plus the time goods
remain in finished inventory, plus the time taken by customers to pay for the
goods.
The stages of operating cycle could be depicted through the figure given:
CASH (Ultimate Stage).
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taken by customers) of raw material stock)
Stage
Stage IV
II
Stage III
Finished goods Work-in-progress
(Period of turnover (Period in production)
of finished goods)
The above figure would reveal that operating cycle is the time that elapses
between the cash outlay and the cash realization by the sale of finished goods
and realization of sundry debtors. Thus cash used in productive activity, often
some times comes back from the operating cycle of the activity. The length of
operating cycle of an enterprise is the sum of these four individual stages i.e.
components of time.
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ADVANTAGE AND DISADVANTAGE OF PREFERENCE CAPITAL
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base year may be any one of the periods involved in the analysis but the
earliest period is mostly taken as the base year. The trend percentage
statement is an “analytical device for condensing the absolute rupee data” by
comparative statements.
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a) Minimum size 25 Lacs
d) While using Commercial Paper, company should ensure that its net worth is
at least 4 crores or more and it has been noted by at least 2 rating
agencies like CRISIL, ICRA, CARE.
CASH BUDGETING
1. Cash Budget shows the policy and programme of cash inflows and
outflows to be followed in a future period under planned condition.
CASH FORECASTING:
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2. Cash Forecasting is an estimate showing amt of cash which would be
available in future period.
3. Cash forecast being statement of future event does not connote any
sense of control.
LEVERAGES
The employment of an asset or source of funds for which the firm has to pay a
fixed cost or fixed return maybe termed as leverage.
i). Operating Leverage results from the existence of fixed operating expenses
in the firm’s income stream whereas Financial Leverage results from the
presence of fixed financial charges in the firm’s income stream.
v). Operational Leverage affects profit before interest and tax, whereas
Financial Leverage affects profit after interest and tax.
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vi). Operational Leverage involves operating risk of being unable to cover
fixed operating cost, whereas Financial Leverage involves financial risk of
being unable to cover fixed financial cost.
Ratio Analysis
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guides concerning the financial health and profitability of the business
enterprise. Ratio analysis can be used both in trend and static analysis. There
are several ratios at the disposal of the analyst but the group of ratios he
would prefer depends on the purpose and the objectives of the analysis.
1. Fraction
2. Percentages
3. Proportion of numbers
These alternative methods of expressing items which are related to each other
are, for purposes of financial analysis, referred to as ratio analysis. It should
be noted that computing the ratio does not add any information in the figures
of profit or sales. What the ratios do is that they reveal the relationship in a
more meaningful way so as to enable us to draw conclusions from them.
Thus the statement prepared to bring out the ratio of each asset of liability to
the total of the balance sheet and the ratio of each item of expense or
revenues to net sales known as the Common Size statements.
Trend Analysis
The base year maybe any one of the periods involved in the analysis but the
earliest period id mostly taken as the base year. The trend percentage
statement is an “analytical device for condensing the absolutely rupee data”
by comparative statements.
Cash Budget
Cash budget is a forecast or expected cash receipts and payments for a future
period. It consists of estimates of cash receipts, estimate of cash
disbursements and cash balance over various time intervals. Seasonal factors
must be taken into account while preparing cash budget. It is generally
prepared for 1 year and then divided into monthly cash budgets.
Working Capital
Working capital is the amount of funds held in the business or incurring day to
day expenses. It is also termed as short term funds held in the business. It is
ascertained by finding out the differences between total current assets and
total current liabilities. Working capital is a must for every organization. It is
like a life blood in the body. It must be of sufficient amount and should be
kept circulated in the different forms of current assets and current liabilities.
The success of organization depends upon how successfully the circulation of
short term fund is maintained smoothly and speedily. Working capital is also
compared with the water flowing in the river as the water is always flowing it
is pure water similarly working capital should be kept circulated in different
short term assets.
Leverages
The employment of an asset or source of funds for which the first firm has to
pay a fixed cost or fixed return may be termed as leverage.
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Operating leverages: is determined by the relationship between firms, sales
revenue and its earnings before interest and taxes (EBIT) which are generally
called as Operating profits. Operating leverage results from the existence of
fixed operating expenses in the firm’s income stream. the operating leverage
may be defined as the firm’s ability to use fixed operating cost to magnify the
affects of charges In sales on its earnings before interest and taxes.
SOURCES OF FINANCE
Short term finance is concerned with decisions relating to current assets and
current liabilities and is also called as working capital finance.
Short term financial decisions typically involve cash flows within a year or
within the operating cycle of the firm. Normally short term finance is for a
period up to 3 years.
1. Cash Credit:
Cash Credit facility is taken basically for financing the working capital
requirements of the organization. Interest is charged the moment cash credit
is credited to the Bank A/C irrespective of the usage of the Cash Credit.
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2. Short term loans from financial institutions: Bank overdraft
3. Bill Discounting:
Bill Discounting is a short term source of finance, whereby Bills Receivable
received from debtors is in cashed from the bank at a discounted rate.
4. Letter of credit
Letter of credit is an indirect form of working capital financing and banks
assume only the risk, the credit being provided by the supplier himself.
A letter of credit is issued by a bank on behalf of its customer to the seller. As
per this document, the bank agrees to honor drafts drawn on it for the
supplies made to the customer. I f the seller fulfills the condition laid down in
the letter of credit.
6. Commercial papers
A company can use commercial papers to raise funds. It is a promissory note
carrying the undertaking to repay the amount or/ on after a particular date.
7. Factoring
A factor is a financial institution which offers services relating to management
and financing of debts arising form credit sales. Factoring provides resources
to finance receivables as well as facilitates the collection of receivables.
There are 2 banks, sponsored organizations which provide such services:
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Since the above sources do not permit the use of funds, for a longer period of
time, the business has to seek further sources, if the need is for a longer
period of time, i.e. This extends up to 3 years and above.
When a firm wants to invest in long term assets, it must find the needs to
finance them. The firm can rely to some extent on funds generated internally.
However, in most cases internal resources are not enough to support
investment plans. When that happens the firm may have to curtail investment
plan or seek external funding. Most firms choose to take external funding.
They supplement internal funding with external funding raise from a variety of
sources.
The main sources of long term finance can broadly divided into:
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The capital structure includes Funds received from the owners of the business
i.e. the Shareholders and therefore called as:
The capital structure also includes Borrowed Funds which are further divided
into:
The Result of which is: The Capital employed i.e. the total long term funds
supplied by the creditors and owners of the firm. It can be computed in 2
ways. First as mentioned above – the non-current liabilities plus owner’s
equity. Alternatively its is equal to net working capital plus fixed assets.
Trading on Equity
Trading on Equity refers to the practice of using borrowed funds, carrying a
fixed charge, to obtain a higher return to the Equity Shareholders.
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With a larger proportion of the debt in the financial structure, the earnings,
available to the owners would increase more than the proportionately with an
increase in the operating profits of the firm.
This is because the debt carries a fixed rate of return and if the firm is able to
earn, on the borrowed funds, a rate higher than the fixed charges on loans,
the benefit will go the shareholders. This is referred to as “Trading on Equity”
Illustration
PARTICULARS A B C A B C
EQUITY 200 200 200 800 600 200
DEBT@15% 800 800 800 200 400 800
TOTAL 1000 1000 1000 1000 1000 1000
EBIT 300 400 200 300 300 300
LESS:INTERSET@15% 120 120 120 30 60 120
NPBT 180 280 80 270 240 180
LESS:TAX@35% 63 98 28 94.50 84 63
NPAT 117 182 52 175.50 156 117
RETURN ON
EQUTIY 58.50 91 26 21.94 26 58.50
%INC/DEC IN EBIT - 33.33 (33.33)
%INC/DEC IN ROE - 55.56 (55.56)
RECEIVABLES MANAGEMENT
The management of accounts receivables management deals with viable
credit and collection policies. A very liberal credit policy will increase sales and
also bad debt losses. On the other hand a conservative credit policy will
reduce bad debt losses but also reduce sales. A good credit policy should seek
to strike a reasonable balance between sales and bad debt losses.
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receivables is less than the cost that the firm has to incur in order to fund
these receivables. This, the purpose of receivables is directly connected with
the firms objective of making credit sales.
(A) Credit Policy: Credit policy means the decisions with regard to the credit
standards, i.e. who gets credit and up to what amount and on what specific
terms. The firms credit policy influences the sales level, the investment .level,
in cash, inventories, accounts receivables and physical equipments, bad debt
losses and collection costs. The various factors associated with credit policy
are:
Credit Period means the length of time customers are allowed to pay for
their purchases. It may vary from 15 days to 60 days.
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(4) Threat of legal action to overdue accounts,
(5) Actual legal action against overdue accounts.
(C) Credit Granting Decision: Credit evaluation helps to judge the credit
worthiness of a prospective customer. Credit granting decision is a procedure
of final decision whether to grant credit to the prospective customer or not.
The decision to grant credit or not depends upon the (cost benefit analysis.
The manager can form a subjective opinion based on credit evaluation about
the chance of getting payment and the chance of not getting payment. The
relative chances of getting the payment or not getting the payment are at the
back of his mind while taking such a decision.
CONCEPTUALS QUESTIONS:
Net worth: Net worth means total equity including reserves and surplus less
intangible assets like goodwill.
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Capital employed=Share capital + reserves & surplus + P&L a/c (cr) +
loans (borrowed funds).
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iii) Selling and distribution expenses
iv) Financial expenses
The expenses ratio is closely profit margin, gross as well as net. It is very
important for analyzing the profitability of a firm. A low expenses ratio is
favourable whereas a high expenses ratio is unfavourable. The implications
of a high expenses ratio is that only a relatively small percentage share of
sales is available for meeting financial liabilities like interest, tax &
dividends and so on.
An analysis of the factors responsible for a low ratio may reveal changes in
the selling price on the operating expenses. It is likely that individual items
may behave differently.
While some operating expenses may show a rising trend, others may
record a fall. The specific expenses ratio for each of the item of operating
may be calculated. These ratios would identify the specific cause.
The current ratio is the ratio of total current assets to total current
liabilities. The calculation is done by using the formula:
Current assets
Current ratio=
Current liabilities
The current assets are those can be converted into cash within a short period
of time during the ordinary course of business of a firm, whereas the current
liabilities include liabilities which are short term obligations to be met within a
year. Thus any change in the composition of current assets &/or liabilities will
lead to a change in the current ratio.
The current ratio of a firm its short term solvency i.e. the ability to meet short
term obligations. The higher the larger is the amount of rupees available per
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rupee of current liability, the more is the firm’s ability to meet current
obligations & assures greater safety of funds of short term creditors.
The flow of funds through current assets and liabilities account is quite
inevitably uneven. Current assets might shrink due to reasons like: - i) bad
debts, ii) inventories becoming obsolete or unsaleable, iii) occurrence of
unexpected losses in marketable securities etc.
The nature of the industry is one of the major cases for difference in the
current ratio. For instance, public utility companies generally have a very little
need for current assets. The wholesale dealers, on the other hand, purchasing
goods on a cash/credit basis for a very short period but selling to retailers on
credit basis, require a higher current ratio.
Secondly the leverage/capital structure ratio. These ratios throw light on the
long term solvency of a firm. It judges the soundness of a firm in terms of its
ability to pay the interests regularly to long term creditors & repayment of
principal on maturity.
Among the leverage ratios, the debt-equity is one of the important ones. It
shows the relationships between borrowed bunds and owner’s capital to
measure the long term financial solvency of the firm. This ratio reflects the
relative claims of the creditors & shareholders against the assets of the firm.
Alternatively, it includes the relative proportions of debt & equity in financing
the assets of the firm. It can be expressed as follows:
Shareholder’s equity
Or
Total debt
Shareholder’s equity.
The D/E ratio is thus, the ratio of the amount invested by outsiders to the
amount invested by the owners of the business.
A high ratio shows a large share of financing by the creditors of the firm while
a lower ratio implies smaller claim by creditors. It indicates the margin of
safety to creditors.
For ex: If the D/E ratio is 2:1, it implies for every rupee of outside liability, the
firm has two rupees of the owner’s capital. Hence there is a safety of margin
of 66.67% available to the creditors of the firm. Conversely if the D/E ratio is
1:2, it implies low safety of margin for the creditors.
A high D/E ratio has equally serious implications from the firm’s point of view.
It would affect the flexibility of operations of the firm, restrict the borrowings
etc. the shareholders would however gain in 2 ways:-
i) with a limited stake they would be able to retain control of the firm.
ii) The returns would be magnified.
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A low D/E ratio would have just the opposite implications.
Thirdly, the profitability ratios. The creditors (long term/short term), the
owners & the management of the company. The management is eager to
measure its operations efficiently. Similarly, owners invest their in the
expectation of reasonable returns. Both these factors depend ultimately on
the profits earned by it which can be measured by its profitability ratios.
1) Related to sales:
a) Profit margin [gross & net]:- It measures the relationship between
profit & sales of a firm.
b) Expenses ratio: - It measures the relationship between expenses
like administration, selling & distribution, financial etc & the sales
of the firm.
2) Related to investments:-
a) Return on investments
i) Return on assets [compare net profits & assets].
ii) Return on capital employed [compare profits & capital
employed]
ii) Return on shareholder’s equity [measure the returns on
owner’s funds]
Both the accounts belong to the non current category and hence there is no
flow of fund. Increase in any of the reserves on account of transfer from P&L
a/c is to be added back to the profits to ascertain funds from operations. If
increase is on account of adjustment of profits on non current accounts it
would not affect the fund. Similarly if the decrease in reserves is on account of
adjustment of loss on non current assets, it would not affect the funds.
Thus effectively the P&L a/c is debited while the fixed asset a/c is credited
with the amount of depreciation. Since both P&L a/c and the fixed asset
a/c are non current accounts depreciation is a non fund item. It is neither
a source nor an application of funds. It is added back to operating profit to
find out funds from operation. Since it has already been charged to profit
but it does not decrease funds from operations. Depreciation should not,
therefore be taken as a source of funds.
As the transaction affects the P&L a/c (a non current item). Payment of
interim dividend results in application of funds.
When the assessment is completed and tax is paid the amount of tax
paid is debited to provision for tax and is treated as an application and
the following entry is passed
Provision for tax a/c Dr.
To bank a/c
Thus the above precautions have to be taken during the calculations of trend
analysis.
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2. It gives information in It gives information in
absolute as well as percentage form only.
percentage form.
3. It deals with same item of Ti deals with different items of
different years. the same year.
4. It is used for times series It is used for cross section
analysis. analysis.
2. These statements can also be used to compare the position of the firm
every month or every quarter. They can be prepared to facilitate
comparison with the financial position of other firms in the same
industry or with the average performance of the entire industry. Such
comparisons facilitate identification of ‘trouble spots’ in a company’s
working and taking corrective measures.
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2. The trend analysis facilitates an efficient comparative study of the
financial performance of a business enterprise over a period of time.
2. Industrial ratios may provide valuable information only when they are
studied and compared with several other related ratios.
TREASURY BILLS:
Treasury bills are obligations of the government. They are sold on a discount
basis for that reason. The investor does not receive an actual interest
payment. The return is the difference between the purchase price and the face
(par) value of the bill.
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The treasury bills are issued only in bearer form. They are purchased,
therefore, without the investor’s name upon them. This attribute makes them
easily transferable from one investor to the next. A very active secondary
market exists for these bills. The secondary market for bills not only makes
them highly liquid but also allows purchase of bills with very short maturities.
As the bills have the full financial backing of the government, they are, for full
practical purposes, risk free. This negligible financial risk and the high degree
of liquidity make their yield lower than on marketable securities. Due their
virtually risk-free nature and because of active secondary market for them,
treasury bills are one of the most popular marketable securities even though
the yield on them is lower.
Lack of regulation: The lack of legal hassles and bureaucratic red tape
makes and inter-corporate transaction very convenient. In a business
environment otherwise characterized by a plethora of rules and regulations,
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the evolution of the inter-corporate market is an example of the ability of the
corporate sector to organize itself in the reasonably orderly manner.
Discount of bills:
A bill arises out of a trade transaction. The seller of goods draws the bill on
the purchaser. The bill may be either clean or documentary (a documentary
bill is supported by a document of title to goods like a railway receipt or a bill
of lading) & may be payable on demand or after a usance period which does
not exceed 90 days. On acceptance of the bill by the purchaser the seller
offers it to the bank for discount/ purchase. When the bank discounts/
purchases the bill it releases the funds to the seller. The bank presents the bill
to the purchaser (the acceptor of the bill) on the due date& gets its payment.
The reserve bank of India launched the new bill market scheme in 1970 to
encourage the use of bills as an instrument of credit. The objective was to
reduce the reliance on the cash credit arrangement because of its amenability
to abuse. The new bill market scheme sought to promote an active market for
bills as a negotiable instrument so that the lending activities of a bank could
be shared by the other banks. It was envisaged that the bank, when short of
funds, would sell or rediscount the bills that it has purchased or discounted.
Likewise, a bank which has surplus funds would invest in bills. Obviously for
such a system to work there has to be lender of last resort who can come to
the succour of the banking system as a whole.
This role naturally has been assumed by the reserve bank of India, which
rediscounts bills of commercial banks upto a certain limit. Despite the
blessings & support of the reserve bank of India, the new bill market scheme
has not functioned very successfully in practice.
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1. Transaction motive
Firms need cash to meet their transaction needs. The collection of cash
(from sale of goods and services, sale of assets, and additional financing) is
not perfectly synchronized with the disbursement of cash (for purchase of
goods and services, acquisition, of capital assets, and meeting other
obligations. Hence, some cash balance is required as a buffer.
2. Precautionary motive
There may be some uncertainty about the magnitude and timing of cash
inflow from sale of goods and services, sale of assets, insurance of
securities. Like wise, there may be uncertainty about cash inflow on
account of purchases and other obligations. To protect itself against such
uncertainties a firm may require some cash balance.
3. Speculative motive
2. Production process:
In the production process there should not be any time lag from the time
of actually receiving the raw materials and the starting of production
process. This means as soon as the materials arrive they should be
introduced in the production process. This therefore meant that the
company will be following the just in time policy(JIT) which simply means
that the requirements of the company will be fulfilled at the time required
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thus reducing the work in progress and thus increasing the efficiency of
the company.
3. Finished goods:
The goods once produced should be held in the company’s possession as
the company’s capital would be locked up in these goods. Thus it is
essential that the company sell all these finished goods as soon as
possible so as to allow the company reacquires its capital employed in the
operating cycle.
4. Receipt of sales:
The receipts of the money from the debtors as soon as possible so as to
regain the money along with the profits.
This is how the operating cycle operates along with how it can be improved so
as to enable the company to regain the money invested in the production of
the goods being produced.
Marketable investments: - Marketable investments are those investments
which are acquired by the company by the employing its surplus funds or cash
temporarily. These investments are short term in nature. These investments
can be disposed off by the company at its free will and thus convert it into
cash as and when the need arises. Hence, these investments are considered
as good as cash, and are often called ‘secondary cash resources’. such
investments are grouped under “current assets”.
Government bonds: - The company can invest its surplus funds in the
various government bonds which will earn them some returns. These
bonds not only beneficial to the government but also to the corporate
business people.
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business. Expansion of these businesses leads directly or indirectly
through their surplus.
Commercial paper:
Eurodollars:
Although most Eurodollars are deposited in Europe, the term applies to any
dollar deposit in foreign banks or in foreign branches of U.S banks. There
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exists a substantial, very active market for deposit and leading of Eurodollars.
This market is a wholesale one in that the amounts involved are at least $
100000. Moreover the market is free of government regulations, as it is truly
international scope.
The rates quoted on deposits vary according to the maturity of the deposit,
while the rates on loans depend on maturity and default risk. For a given
maturity, the leading rate always exceeds the deposit rate. The bank makes it
money on the spread. The benchmark rate in this market is 6-month London
interbrain offer rate. (LIBOR). This is the rate at which banks make loan to
each other. All others borrowers are quoted rates in excess of this rate, such
as LIBOR + 1\2 PERCENT.
The working capital needs of a firm are influenced by numerous factors. The
important ones are:
• Nature of business.
• Seasonality of operations.
• Production policy.
• Market conditions.
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• Conditions of supply.
Nature of business:
The working capital requirement of a firm is closely related to the nature of its
business. A service firm, like an electricity undertaking or a transport
corporation which has a short operating cycle and which sells predominantly
on cash basis, has a modest working capital requirement. On the other hand,
a manufacturing concern likes a machine tools unit, which has a long
operating cycle and which sells largely on credit, has a very substantial
working capital requirement.
Seasonality of operations:
Firms which have marked seasonality in their operations usually have highly
fluctuating working capital requirements. To illustrate, consider a firm
manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the
summer months and drops sharply during the winter period. The working
capital need of such firm is likely to increase considerably in summer months
and decrease significantly during the winter period. On the other hand, a firm
manufacturing product like lamps, which have even sales round the year,
tends to have stable working capital needs.
Production policy:
Market conditions:
If the market is strong and competition weak, a firm can manage with a
smaller inventory of finished goods because customers can be served with
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some delay. Further, in such a situation the firm can insist on cash payment
and avoid lock-ups of funds in accounts receivable –it can even ask for
advance payment, partial or total.
Conditions of supply:
The inventory of raw materials, spares, and stores on the conditions of supply.
If the supply is prompt and adequate, the firm can manage with small
inventory. However, if the supply is unpredictable and scant, then the firm, to
ensure continuity of production, would have to acquire stocks as and when
they are available and carry large inventory on an average. A similar policy
may have to be followed when the raw material is available only seasonally
and production operations are carried out round the year.
With MMP, an auction is held every 49 days. This provides the investor with
liquidity and relative price stability as far as interest rate risk goes. It does not
perfect the investor against default risk. The new auction rate is set by the
forces of supply and demand in keeping with interest rates in the money
market. A typical rate might be 0.75 times the commercial rate, with more
creditworthy issuers commanding an even greater discount.
As long as enough investors bid at each auction, the effective maturity date is
49 days. As a result, there is little variation in the market price of the
instrument over time. The auction where there are insufficient bidders, there
is default rate for one period that is frequently 110 percent of the commercial
paper rate. In addition, the holder has the option to redeem the instrument at
its face value.
These provisions are attractive to the investor as long as the company is able
to meet the conditions. If the company should altogether default, however the
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investor loses. There have been only a few instances of failed auctions and
default.
Portfolio Management:
The decision to invest excess cash in marketable securities involves not only
the amount to invest but also the type security in which to invest, to some
extent, the two decisions are interdependent. Both should be based on
evaluation of expected net cash flows and the uncertainty associated with
these cash flows. If future cash –flow patterns are known with reasonable
certainty and the yield curve is upward sloping in the sense of longer term
securities yielding more than shorter term ones, a company may wish to
arrange its portfolio so that securities will mature approximately when the
funds will be needed. Such a cash flow pattern gives portfolio, for it is unlikely
that significant amounts of securities will have to be sold unexpectedly.
These are various reasons that a company may want to hold cash. Some of
the important reasons for holding cash would be to meet immediate and
unexpected expenses that may arise during the course of the running of the
business. Some of these expenses may be attributed to the spending on
stationery or may be on other such miscellaneous such as purchase of
beverages of refreshments for any of the company’s guests.
Ans) The current ratio is the ratio of current assets to current liabilities. The
current ratio of a firm measures its short-term solvency, that is, its ability to
meet short-term obligations. As a measure of short term/current financial
liquidity, it indicates the rupees of current assets available for each rupee of
current liability/obligation.
The higher the current ratio, the larger is the amount of rupees available per
rupee of current liability, the more is the firms ability to meet current
obligations and greater is the safety of funds of short term creditors.
So, the increase in current ratio from 1 in 1999 to 2.5 in 2000 indicates good
liquidity position of the firm. It indicates that firm has greater working capital
to meet its day to day requirements. The firm can meet its short-term
obligations effectively.
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Increase in current ratio means increase in current assets, which may be
either stock or cash or debtors. Increase in stock or any other current asset
indicates good short-term solvency of the firm.
The standard current ratio is 1.33:1 and the firm’s current ratio has increased
from 1 in 1999 to 2.5 in 2000. It indicates that the firm is improving its
current ratio. The firm had current ratio of 1:1 i.e. for every one rupee of
current liabilities current assets of one rupee are available to meet them. But
the firm’s current ratio of 2.5:1 in the year 2000 indicates that for every one
rupee of current liability, the firm has two and a half times current asset to
meet them, which means more working capital.
This will improve short-term solvency of the firm. The increase in the current
ratio may also due to decrease in current liabilities i.e. creditors, bills payable,
etc.
The proprietary ratio is a test of the financial and credit strength of the
business. It relates shareholders funds to total assets i.e. total funds. This
ratio determines the long term or ultimate solvency of the company. In
other words, proprietary ratio determines as to what extent the owner’s
interests and expectations are fulfilled from the total investments made in
the business operation. The debt service ratio will also be considered. This
ratio is also called as interest coverage ratio.
The purpose of this ratio is to find out the number of times the fined
financial charges are covered by income before interest and tax. It
indicates whether the company will earn sufficient profits to pay
periodically the interests charges. Higher the ratio it is favorable. It shows
that the company will be able to pay interest regularly.
In this situation, the company should refer to earning per share ratio and
price earning ratio. The 2 main points to be considered under this content
are
1) Payment of dividend
2) Appreciation of investment
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Q. Explain the solvency and profitability ratios.
Ans.
c) Capital Gearing Ratio ⇒ Capital Gearing Ratio brings out the relationship
between two types of capital i.e. capital carrying fixed ratio of interest or
fixed dividend and capital that does not carry fixed rate of interest or fixed
dividend.
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Quick Ratio = Quick Assets
Quick Liabilities
These ratios are intended to reflect the overall efficiency of the organization,
its ability to earn a reasonable return on capital employed or on shares issued
and the effectiveness of its investment policies. Profitability Ratios includes:
1) Product
a) Gross Profit Ratio ⇒ Gross profit brings out the relationship between
gross profit and net sales. It is also known as ‘Turnover Ratio’ or ‘Margin’
or ‘Gross Margin Ratio’ or ‘Rate of Gross Profit’. It is expressed as % of net
sales.
Gross profit = Gross Profit × 100
Sales
b) Net Profit Ratio ⇒ Net Profit Ratio indicates the relationship between net
profit and net sales. Net profit can be either operating net profit or net
profit after tax or net profit before tax. This ratio is known as ‘Margin or
Sales Ratio’.
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Return on capital employed = Net profit before interest and tax
× 100
Capital employed
c) Return on Equity Share Capital ⇒ This ratio indicates the rate of earning
on the equity or ordinary share capital. This is expressed as a % or in
absolute monetary terms. Alternatively, this may be expressed as an
amount of return per equity share but as a % of the equity capital, it is
easily understood. This ratio is also known as ‘The Rate of Return on Equity
Capital’.
Name any 5 sources of funds & classify them into short-term & long
-term funds?
Ans.)
Issue of equity share & preference shares = Long- term funds.
Issue of debentures = Long- term fund.
Receipt of public deposits & other unsecured loans = Short- term
fund.
Receipt of securities premium = Short- term fund.
Income from long-term investments = Long-term funds.
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Q) Uses of fund flow statements:
Ans.)
Fund flow statements are prepared for internal & external uses.
There are many parties who are interested in the funds flow
statements. Shareholders, investors, bankers, creditors & the
management are among them.
Ans.)
Funds flow statement is a financial statement, which shows as to how a
business entity has obtained its funds & how it has applied or employed
its funds between the opening & closing balance sheet dates(during the
particular year/period.
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3. Funds statement serve as effective tools to the management for
economic analysis as it supplies additional information, which cannot be
provided by financial statements, based on historical data.
11. Funds flow statement clearly indicate how profits have been invested,
whether investments in fixed assets or inventories or ploughed back.
In the preparation of cash flow statement all the item that increase/decrease
cash are included but all those items that donot have any effect on cash are
excluded. Hence, it is essentially a tool of short term financial planning. Cash
flow information is useful in assessing the ability of company.
It measures the relationship between the Quick assets & Quick liabilities.
The quick ratio or liquid ratio is calculated by dividing Quick assets by Quick
liabilities.
C.R. = C.A.
C.L.
It is more of qualitative concept. This ratio is the true test of business or firms
solvency & liquidity position & this will indicate the inventory hold-ups when
studied along with the current ratio.
Financial statements for a number of years are reviewed and analyzed. The
current years’ figures are compared with the standard bases year. The
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analysis statement usually contains figures for two or more years and
changes are shown regarding each item, from the base year, usually in the
form of percentage. Such an analysis gives considerable insight into levels
and areas of strength and weaknesses. E.g. Trend Analysis.
Opportunity cost of capital is “the rate of return associated with the best
investment opportunity for the firm and its shareholders the will be
foregone if the project presently under consideration by the firm were
accepted.” Its is also called as ‘Implicit Cost’. In case of retained earnings,
it is the income, which the shareholders could have earned if such earnings
would have been distributed and invested by them.
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Usually prepared by junior Usually prepared by senior
management team for perusal of management for perusal of
senior managers. Directors, Owners.
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the asset usually for an agreed period of time in return for the payment of
rent.”
Important features here are:
1. Owner and User are different
2. Depreciation claim is not with the user (lessee) as he is not the owner.
Lessor (owner) claims the depreciation.
3. Lease (rent) payment is a tax-deductible expense.
4. In most transactions, asset is delivered directly to the lessee by the
manufacturer/ supplier. Lessor makes payment to the supplier and
receives rent from lessee in future periods.
5. Lease funded assets do not alter Debt: Equity ratio.
Hire Purchase: In case of Hire Purchase transaction, the goods are delivered
by the owner to another person on the agreement that such person pays the
agreed amount in periodical installment.
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a broker purchases the company's shares on the home stock market and
delivers those to the depository's local custodian bank, which then instructs
the depository bank, to issue Depository Receipts. Depository receipts could
be traded freely just like any other security, either by exchange or in the
over-the-counter market and could be used to raise capital.
Points to remember:
Leverages:
• Business Risk is risk due to fixed operating costs (operating leverage)
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• Financial Risk is risk due to fixed financial costs (interest, preference
dividend) i.e. due to financial leverage.
• Financial Leverage is also called as ‘Trading on Equity’
• Direct Costs usually would mean variable costs
Ratio Analysis:
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